Angela Merkel said Germany's highest court had sent a powerful message to the rest of Europe and beyond, after it paved the way for the creation of a €500bn rescue fund to tackle the eurozone's debt crisis.

Markets rallied following the decision by the eight justices of the constitutional court in Karlsruhe to let Germany ratify a treaty to establish the European stability mechanism (ESM). The euro reached a four-month high and European stock markets rose after the court imposed conditions that were less burdensome than German parliamentarians and other ESM supporters had feared.

The ESM can now start up next month and become fully operational by the new year, despite the warnings of analysts who say it will not work. The ruling was considered one of the most important in the court's 61-year history.

A key condition attached to the ruling means that Germany's liabilities will be capped at €190bn. But the fact that the Bundestag and Germany's ESM representative can override the limitation led some observers to say it was a bluff, introduced to assuage the concerns of German taxpayers whose frustration at the prospect of having to bail out indebted southern European countries indefinitely has been on the rise.

A poll before the ruling showed that 54% of Germans wanted the court to block the ESM, amid growing fears that Germany is ceding too many powers to European institutions. The court was petitioned by 37,000 Germans arguing that the ESM was anti-constitutional.

The ruling is a breakthrough for Merkel and allows the go-ahead of the two-pronged approach she favours of both bailouts and budgetary discipline in the form of the ESM and the fiscal pact. She said the decision sent a strong signal of Germany's commitment to Europe, and was positive news for German taxpayers, who she said had been provided with certainty.

"This is a good day for Germany, a good day for Europe," she told the Bundestag. "We haven't yet overcome the crisis, but we have achieved our first steps."

Frank-Walter Steinmeier, leader of the opposition Social Democrats, expressed his relief that the ESM – whose creation had been substantially delayed by the constitutional court's deliberations – could now start to work. "The significance of this decision for the future of Europe cannot be underestimated," he told the Bundestag.

Neil Prothero, of the Economist Intelligence Unit, said the decision would come as a relief to policymakers across the eurozone. "A decision against the ESM would have thrown the region's crisis response strategy into disarray," he said.

But Gunnar Beck, an EU analyst at London's School of Oriental and African Studies, called the decision "a completely absurd judgment from a legal point of view", because it meant Germany's liability was fixed "unless it is decided otherwise, which means there's no limit to it".

He was gloomy about the long-term effects of the decision, predicting that the markets' enthusiasm would not last. "In the short term the market will be booming, but in the long term this means unending horror. Germany is locked in now and it means that if the ECB buys unlimited bonds, Germany's liability is unlimited as well," he said. "Germany is like a bank that has lent too much to its biggest client so that it has to continue lending until the client goes bust".

The court had been under huge pressure not to torpedo the ESM, amid fears that it would cause the destruction of the euro and have a chaotic effect on the global economy. Andreas Vosskuhle, the court's president, said the economic and political consequences of delaying the law's introduction were "almost impossible to calculate reliably".

Despite repeated claims of the court's independence, there have been strong suggestions of at least one high-level meeting between the government and the court, reports about which led to speculation that the two bodies might have worked closely on a face-saving solution.

A little light relief amid the gravitas was offered by a slip of the tongue by Vosskuhle, who called the petitions to block the ESM "justified" before changing it to "unjustified" after being corrected by a colleague, as peals of laughter filled the courtroom.

Bank power balance

The EU executive has unveiled new laws empowering the European Central Bank to police 6,000 banks in the eurozone, a step towards a more centralised federation in response to almost three years of the bloc's currency crisis.

The aim, accompanied by decisions on direct eurozone recapitalisation of struggling banks, is to establish a far more robust supervisory and regulatory regime over the banks and to break the pernicious links between weak sovereigns and vulnerable banks feeding Europe's debt crisis.

While broadly welcomed by all of the EU including Britain, which will take no part in the new regime, the detail of the draft legislation will be hugely contested by EU governments between now and the end of the year, with London and Berlin squaring off as opposite poles in the argument.

Signalling the new draft represented just the start of months of wrestling over the outcome, a British diplomat said: "A banking union for the euro area must also respect the integrity of the single market for the whole of the European Union, and we'll ensure the agreement on it does that."

Germany strongly resists planned supervision of all 6,000 banks, seeking to minimise the ECB's remit to just 20-odd "systemic" banks, the biggest in the eurozone, which would include only two German institutions. Berlin is also reluctant to rush into using eurozone bailout funds for direct bank recapitalisation.

Berlin, the first to call for the "banking union" and to insist that the supervisory powers be vested in the ECB in Frankfurt, appear to be keen on the policing of eurozone banks as long as few as possible German banks are controlled.

The British, remaining outside the new regime, are worried about the impact of the new system on non-euro members, on the European single market, and on the City of London, disputing complicated new proposed voting arrangements they fear could leave them defenceless against moves to penalise London-based banks while making it harder to force action against eurozone banks.

For the ECB to gain the sweeping new powers,including that to grant and withdraw banking licenses in the eurozone, all 27 EU governments must agree, giving the UK a veto if they fail to force concessions.

The ECB's supervisory role is to be phased in, according to the plan, kicking off next January with extensive intrusive powers of scrutiny over weak banks already being bailed out, notably in Spain, extending to the 20-30 systemic banks by the middle of next year, and then putting all 6,000 banks under ECB policing by the beginning of 2014.

The draft law concerns solely supervisory powers. The plan is to then expand the regime over a few years to include a common eurozone resolution authority and funds for winding up or restructuring failing banks as well as common deposit guarantee schemes for eurozone savers.

Both elements are also contested by Berlin which is wary of being made co-liable for the costs of other countries' banking failures and savings guarantees. While the new ECB regime will apply to all of the eurozone, non-euro countries can also come under the system without gaining voting rights in the new ECB supervisory board. Of the non-euro countries, Poland is the keenest to join but is also arguing for better terms.

While Michel Barnier, the single market commissioner in charge, sounded optimistic on Wednesday that several non-euro countries would join the new supervisory system, senior officials expect it to start with only the 17 single currency countries.

The trickiest part of the new system concerns relations between the ECB authority representing the 17 and the London-based European Banking Authority which groups national supervisors and coordinates between them.

The Germans are scathing about the performance of the EBA, the ECB in Frankfurt sees it as a rival, while the British are worried that the role of the EBA is actually being strengthened and could damage UK interests.